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Apr 08, 2010


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Paul, I've been reading your posts and the artical on externalities. I can't agree with all that you say. One day the free market will find solutions to the carbon based sources of energy that are extremely effective. (nuke power anyone?) But until that time we have little alternative and putting higher tax's on energy we all must use (no matter what you name it I.E. cap & trade) will place a burden on people who are altready taxed at the limits(those that really pay taxes anyway..about half the people in the US)
There are as you know other forces at work here. But doing such things in the name of climate control...?? Wow...this is almost like talking about the theory of evolution as a given fact. The more you say something doesn't make it true...

Michael W.Kruse

David, I was hesitant to use the climate change example because I was afraid people would immediately spin off into whether climate change is a real threat or not. That is irrelevant to my point.

Even if it is not real, I'm asking you to imagine it is and that on balance the consequences will be negative. We are conducting a thought experiment. What that would mean is that we are inflicting significant costs on others and on future generations that aren't factored into our market transactions. The approaches I mentioned are measures to correct these externalities. I'm using climate change as a hypothetical example.

You are addressing a different question: Is anthropogenic climate change real? If it is not, then we don't have an externality and there is nothing to correct. That is beyond the scope of my post to address that. I'm simply asking readers to assume is true for the sake of illustrating of my point.

And assuming the climate change scenario, nuclear power would indeed be a useful alternative form of power. But adding the carbon tax, or using cap and trade, would make the carbon fuels more expensive in the market making alternatives more economically attractive, thus spurring their quicker adoption. The carbon tax, and cap and trade, are market based solutions (assuming they could be correctly implemented.') They simply make sure that market prices reflect their true costs.


Michael, please excuse my error. It's just really hard for me to get my thoughts around this issue. There is no question about the political & business interests regarding externalities and the affect they have on people.
Do you really think it's the job of govt and all the resources govt has to affect the free market system in such dramatic ways to bring about political ends in the name of protecting the "good of the people & environment" ? I know, this is a naive question, but none the less it is probably a sin to put burdens on future generations for the expediency of costs. Especially in hopes of free market development. Development comes from inspired people, not through punishment...or negative incentives. (my hope anyway) True costs is an interesting phase. As if it can be pinned down in any real way when dicussing such things. I would disagree that carbon tax, cap and trade and ideas such as these are market based. They are political if not govt directed type policy to further specific agendas of some.

Michael W. Kruse

"Development comes from inspired people, not through punishment...or negative incentives."

The idea behind accounting for externalities is not to impose negative incentives.

"...to affect the free market system in such dramatic ways to bring about political ends in the name of protecting the "good of the people & environment" ?"

It is also not about achieving political ends (though that will not stop politicians from trying to do so.)

It is to make sure the FULL cost of the market transactions is borne by those who are a party to the transaction, and not shifted off to others who must involuntarily absorb them.

If you open up a chicken farm in your backyard in my urban neighborhood, you and your customers get the benefit of exchanging the eggs you produce. I get no benefit from the transaction but my peace and quite is disrupted, I have to live with the odor, and my property values are adversely affected. I'm bearing part of the cost of your business.

If you open up a factory that dumps chemicals upstream from my place that kills fish and contaminates the water, I now can no longer fish in the stream or let kids near the water. You have exacted an involuntary cost on me and reduced my property value without compensating me for it.

If you have a factory that is putting cancer causing gases in the air, then you are placing a health care cost on the rest of the community that they did not agree to.

The free market alone is not going to address these issues. Using my urban transportation analogy, some rules of the rode need to be put in place that shield against these kinds of abuses.

When I a say that the tax, or cap and trade, are market based, I'm comparing this to the alternative of government entering the picture and either outright banning certain activities or dictating what solutions will be implemented.

Think in these terms. Some day fossil fuel is going to be depleted. As the price creeps up, entrepreneurs will enter the market with new technologies that are relatively cheaper to the fossil fuels at that time. That is the free market answer to the problem, yes?

If we conclude that fossil fuels are actually taking a significant toll on the environment and human habitat that we had not previously realized, then that means the market costs are not reflecting the true cost of using the fuel. The fossil fuel tax simply makes that fuel relatively more expensive to the alternatives and speeds up the process of entrepreneurs entering the market with alternatives. No government solution is imposed. The free market solves the problem.

Also, with cap and trade, a fixed emission level is set and licenses are sold. But government doesn't impose a technology solution for companies to keep to certain level of emission. Firms innovate and strategize on how to meet these demands. It is a market based solution.

That externalities exist and must be addressed is noncontroversial across the whole spectrum of economists. What is controversial is just how much cost markets externalize and which solutions are most preferable. Libertarian types to distrust government solutions and try to resolve externality problems getting competing property rights better articulated (they would share your concern about government's ability to approximate appropriate costs versus using these methods for purely political ends.) Liberals tend to be very optimistic about the ability of government to impose taxes, to regulate, or to do cap and trade, in an equitable balanced manner. I think most economists are probably somewhere in between.



I guess we will just disagree on a few points. I'm not an economist by any measure. I'm the one on shakey ground and not you! I don't see the solution in imposing a tax to make something relatively more expensive to speed up development and or alternatives. Sounds like being directive in a dangerous way, because who then sets the tax and for what reason or motive? It sure wouldn't be the free market system...Govt may impose regulations, limits, tax and in the end probably to their own purpose. I don't think govt today looks out for the best interest of the people. (I'm not anti govt) But there are very few real Statesmen anymore. But in a perfect world you may be on to something. Trying to put total costs on almost anything these days is difficult at best. Especially if you take into account those things we don't like to discuss, like what various countries do to it's people who labor for almost no pay, materials used that could be harmful, extreme environmental costs, and we could list a host of things...Don't think trying to explain market costs helps a great deal in the long run no matter what the influence may be. Just maybe the price of goods sold would be a better measure taking into account all that influences the bottom line of a particular product or service.
The issue of fuel is a scary one. I agree one day we (the world) will run out I assume. Just hope it's not in my life time...it will not be a pretty sight. Then I don't think it will much matter how costs affect much of anything. That is as you say the market steps in and develops an alternative based on costs that will go out of sight. Just because of basic supply and demand.


I suspect that it depends on what good or service it is we are trying to tax into oblivion.

Look at the price of gasoline (petrol) in the UK. It hit £1.20/liter yesterday. (I make that approximately $6.90 per gallon at current exchange rates.) That hasn't stopped "the British people" in aggregate from driving. Don't get me wrong. I'm actually in favor of environmental sustainability, but raising taxes really doesn't seem to be the way to get people to stop driving.

Equally, I'm pretty certain that slapping a 1 cent tax on a can of soda pop is probably not going to reduce the demand for that either.

In general, I wonder how effective taxes are at stopping certain behaviors? My suspicion is that they are probably not terribly efficient at changing most behaviors but they do, of course, raise money for the governmental authority imposing the tax.

Michael W. Kruse


It's okay that we disagree. But I still sense we are not clear about the nature of the dilemma of an externality.

A free market transaction isn't free simply because there is no government interference. For a market transaction to be free, the buyer and seller must be accounting for ALL the costs associated with that transaction. If others external to the transaction are being made to carry part of the cost, then we no longer have a free market transaction. Others are bearing costs they did not chose to incur and they receive little to no benefit. They are in effect being force to subsidize the economic behavior of others. It is a form of theft.

Secondly, when a tax is used in an externality scenario it is called a Pigouvian Tax (named after Arthur Pigou). This is not a punitive tax or a sin tax. Sin taxes are targeted to stop an objectionable behaivor. Pigouvian taxes are intended to make market transactions bear the actual costs of that transaction ... no more, no less.

I don't think I was clear in my previous comment. Let me restate. The tax makes sure the true costs are covered by the parties to a market transaction. It can be argued that the reason there has not been a quicker move to alternative fuels is because carbon based fuels are under-priced in the marketplace, having externalized some costs. By making carbon fuel bear its true cost their would be a more rapid shift to alternatives. There are two ways of coming at this that sound similar but are actually quite different.

1. Let's add a carbon tax of X amount because we want alternative fuels to become more attractive.

2. Let's add a carbon tax of X amount because the market price is not capturing the total cost (and this would have the side effect of spurring alternative fuels but it is not the basis for making the adjustment.)

Like you, I'm not persuaded of the need to try to adjust prices for what some are claiming is a serious climate change externality. And you correctly note that identifying the tax amount to balance the cost is very problematic. To this, I would also add that in a democracy I think it would be very difficult to impose a significant Pigouvian tax unless there is widespread support. People simply vote a new crop of legislators to repeal it.

Nevertheless, the bottom line is that markets do not handle all transactions efficiently and justly. Pigouvian tax is just one tool in the toolbox economists talk about as means to address externalities. The bigger issue is that we must be aware that externalities exist and work to address them.

Michael W. Kruse


As I was writing to David above, the purpose of Pigouvian tax is not at it is core about getting people to change or stop their behavior. It is to make certain that all cost have been factored into a market transaction. Naturally, if the price of something goes higher it will likely have some impact on how frequently it is used. But getting people to do something is not the prime motive. Capturing costs in the transaction will.

As to a what price levels would create change, economists talk about price elasticity. Consumption of some products is highly sensitive to minor changes in prices (i.e, elastic.) Others require significant shifts before consumption changes (inelastic). Back in 2008 gas prices kept rising with seemingly little impact on consumption. But when national averages hit about $4.00, there was for the first time in years a significant fall-off in miles driven by Americans.


It seems to me the more and more people the harder it will be for the externalities not to affect us all. As we are more and more global in our economies we all are or will be effetced by transaction costs in negitive and positive ways. Behavior can not be regulated in a free market system (we are not rats) unless like Pam says you tax folks or charge amounts until it becomes silly. Like those who have the habit of smoking and are affetced by extremely high tax.
I agree that externalities exist, and we have to find ways to deal with them so as not to hurt people, or cost them in ways unexpected. I hate to pay for my baggage when flying as a result of high fuel costs... Not sure thats an externality. In any case it's a complicated issue I'm not really able to sort out. Like trying to come to a solution of what in the world wall street was thinking that led to the housing bubble / bust. Greed I guess. Greed is an economic driver it seems by people with little moral and ethical standards of any kind but what should we expect when truth is held relative by the larger society in which we live. Not sure how this effects true cost relative to externalities but I'm sure there's a connection.

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